Tobacco Sees Best Gain Since April After 17% Drop: Muni Credit

In July 2012, Moody’s projected almost three-quarters of the $20.4 billion in tobacco bonds it grades will default if cigarette consumption declines 3 percent to 4 percent annually. Photographer: Andrew Harrer/Bloomberg

Sept. 17 (Bloomberg) -- The $84 billion market for junk-rated tobacco bonds, one of the weakest areas of municipal debt
this year, is rallying to a one-month high after a ruling
against cigarette makers in a payment dispute with states.

Obligations from New York and Ohio, which account for about
a third of high-yield tobacco debt, are leading the gains.
Yields on 29-year New York City bonds backed by payments under a
1998 national settlement with cigarette companies fell to 7.76
percent on Sept. 13, the lowest in a month, data compiled by
Bloomberg show. The extra interest rate on Ohio securities
maturing in June 2047 dropped to a one-month low on Sept. 13,
two days after the arbitrators’ findings.

Such securities have still lost about 14 percent in 2013,
about three times the decline in the rest of the $3.7 trillion
local-bond market, according to Barclays Plc data. That pared
the 2013 loss from 17 percent on Sept. 6. Only junk-rated water
and sewer bonds have fared worse, falling almost 18 percent.

“For the states that won, clearly there should be
improvement in the bonds,” said Richard Larkin, director of
credit analysis in Iselin, New Jersey, at Herbert J. Sims & Co.,
which manages $2 billion of fixed-income. “What I worry about
is people read too much into this and they apply it to all
tobacco bonds when it’s not the case.”

Perpetual Funds

The tobacco bonds are joining the biggest muni rally since
April, as investors are buying Illinois and California debt
before the Federal Reserve’s two-day meeting beginning today.

Under the 1998 national settlement, Phillip Morris USA,
Lorillard Inc. and Reynolds American Inc. agreed to make annual
payments to the states in perpetuity to resolve their liability
for health-care costs attributed to smoking.

Some states and cities borrowed against the payments, which
are based on cigarette shipments. Most of the tobacco bonds
assessed by rating companies are graded junk because of falling
consumption and because the securities lack state backing.
Including investment-grade debt, localities have sold about $97
billion of the securities, Bloomberg data show.

Arbitrators found last week that nine states “diligently
enforced” state laws against tobacco makers that didn’t
participate in the 1998 settlement between the companies and 52
states and jurisdictions. Six states lost in arbitration,
according to Larkin.

Five of the nine states that won -- New York, Ohio,
Illinois, Iowa and Washington -- have issued tobacco bonds and
stand to recover more than $180 million withheld by the
companies related to 2003 payments, according to news releases
from the states’ attorneys general.

Default Delay

For issuers such as Nassau County, on New York’s Long
Island, “this decision will definitely push back the date of a
possible default for a good number of years, and may actually
allow local issuers to pay 100 percent of their securitized
tobacco debt in full and on time,” Larkin said in an e-mail
last week.

Buyers demanded about 3.63 percentage points of extra yield
to own the Ohio bonds on Sept. 13, the smallest yield spread
since Aug. 13. The securities, issued by the Buckeye Tobacco
Settlement Financing Authority, are rated B3 by Moody’s
Investors Service, six levels below investment grade.

The tobacco companies have already paid states $62.5
billion, according to findings by arbitrators.

Level Field

Since the national settlement imposed significant costs to
the tobacco companies that participated, states adopted laws
assessing similar costs on cigarette makers that didn’t
participate to level the playing field.

A dispute later arose between the major tobacco makers and
the states about “diligent enforcement” of the statutes. As a
result the tobacco companies have withheld more than $7 billion
due to that states for the years 2003 to 2012.

In New York, the disagreement centered on the state’s
policy of not taxing cigarette sales on Indian reservations. The
state didn’t collect payments from companies that didn’t join
the national settlement on reservation sales. The panel said
there was no evidence to support the tobacco companies’ argument
that New York arbitrarily decided to impose excise taxes and
collect payments from sales of cigarettes on Indian reservations
because it was state policy not to collect taxes on those sales.

The arbitration decision follows settlements over the
disputed payments the tobacco companies have reached with 22
states and jurisdictions since December.

One Slice

The disputed funds represent about 10 percent of the annual
payments to states, Richard Akulich, vice president of
institutional sales and trading at Mesirow Financial Inc.’s muni
department in San Francisco, said in an interview.

The added flow of money may still be overwhelmed by other
risks to bondholders that could reduce the companies’ annual
payments, such as declining cigarette consumption and tax
increases at the federal, state or local level, Larkin said.

In July 2012, Moody’s projected almost three-quarters of
the $20.4 billion in tobacco bonds it grades will default if
cigarette consumption declines 3 percent to 4 percent annually.
The average annual decline since 1999 has been 3.2 percent,
according to Mesirow.

After the arbitration panel’s decision last week, the
tobacco companies said they will pursue claims for the disputed
2004 payments against states that haven’t settled.

Arbitration Questions

“The arbitration rulings are positive for those states
that have won, but there are a lot of questions about how future
arbitrations proceed,” said Peter Bianchini, managing director
at Mesirow.

Localities are set to sell about $4 billion in long-term
debt this week at the lowest interest rates since August.

The ratio of the yields, a gauge of relative value, is
about 105 percent, compared with an average of 93 percent since
2001. The higher the figure, the cheaper munis are in
comparison.

Following is a pending sale:

Washington plans to sell about $295 million of federal
highway grant-anticipation revenue bonds as soon as today to
help finance a $4.1 billion bridge across Lake Washington,
between Seattle and Redmond.